June 29, 2005

Know Your Entrepreneur's Magic Number

One of my objectives on Sacred Cow Dung is to discuss various aspects of the art of building new companies and new industries.

One of the most central areas to discuss is RISK.

The ability to assess, manage, and mitigate risks is the cornerstone skill set of all successful entrepreneurs and venture investors in their quest to build new companies and new industries.

Depending on who you talk to, you can end up with a pretty long, and daunting, laundry list of potential risks associated with any new venture. However, I tend to lump each risk under three broad categories of risk —

Market Risk

Execution Risk

Financing Risk

I have a very practical reason for dividing risks under these three categories. The approach and tools used to assess, manage, and mitigate risk differs — most between categories — not so much within categories. By sorting the specific risks associated with a specific venture, the list of associated risks is now transformed into a practical set of key operating plan objectives required for success. This approach makes a complex list much simpler to communicate and easier to monitor over time (and complements SWOT and MOST analyses).

That’s fine and dandy and we will talk more about this in later posts – BUT there is another aspect of risk management that is not often addressed consciously by entrepreneurs and their investors. And, in many ways it may be the most important factor to consider while trying to align incentives between management and investors.

Know Your Entrepreneur’s Magic Number!

This is the flip side of David Beisel’s Know Your VC’s Magic Number post on his terrific Genuine VC site. While it is important for both the potential VC and the pitching entrepreneur to know what the VC is looking for in a deal. It is equally important, and often harder to assess, what’s in it for the entrepreneur. Enter — The Personal Risk Tolerance Curve and it’s magic inflexion point that both entrepreneurs and VCs need to be more conscious of.

The Personal Risk Tolerance Curve

If you look at the professional life of a typical successful entrepreneur, their ability to tolerate personal risk varies over time. If one assumes a linear increase in net worth over time (rarely the case) then this curve also roughly correlates to three distinct phases.

Phase I — The entrepreneur has essentially no personal net worth

Therefore the entrepreneur has nothing to lose and therefore is willing to tolerate high degrees of personal risk.

Phase II — The entrepreneur is building personal net worth

What is interesting is that as the entrepreneurs net worth builds (even on paper), their reputation as risk takers (a myth to be discussed in another post) is increasingly in conflict with their actions. As entrepreneurs realize they have more and more at stake, they become more and more risk-averse — until they hit their “Personal Magic Number”.

Phase III — The entrepreneur feels relatively secure financially

Once an entrepreneur’s net worth (or anticipated net worth) exceeds their “Personal Magic Number”, their personal risk-tolerance begins to grow in proportion to the growth of their net worth in excess of their “Personal Magic Number.”

This analysis may seem overly simplistic (as my observations tend to be), but it is something an entrepreneur should become conscious of because his personal risk tolerance profile will color his judgement over the lifetime of his career.

Equally, VC’s should be conscious of assessing — not only a given entrepreneur’s Magic Number — but also where he is along his personal curve.

Young recent college graduates behave differently from middle-aged first time entrepreneurs, serial entrepreneurs behave differently from first-time entrepreneurs, senior managers behave differently than founders, etc., etc. — in part, due to the existence of their Personal Risk Tolerance Curves and where they are along them.